India: Startup Fund Raising: Key Aspects

As per a 2015 survey by Nasscom (the National Association of
Software and Service Companies) India has paved the way to secure
the third position in the world with three to four startups
emerging every day, primarily in the areas of e-commerce, consumer
services and aggregators. The report also states that total funding
in 2015 had grown by about 125% from a year earlier. Various
campaigns launched by the government – Start Up India, Make
In India, Digital India, National Policy for Skill and
Entrepreneurship – and various other policy measures in the
form of tax rebates have contributed to a favourable startup
ecosystem.

A startup may seek funding for varied reasons. Funding can
provide capital required to back its business plan or the pace at
which it aims to grow, visibility and reputational benefits, a
mentor that will constantly guide it in making critical business
decisions, risk allocation and other benefits.

Legal due diligence

A startup may go through various stages of fundraising,
including angel funding, seed round funding and growth/early stage
funding. After the angel funding stage, an important exercise that
a startup will have to go through during a fundraising process,
after having executed a term sheet, is a legal due diligence.

A legal diligence exercise is typically conducted at the seed
and the growth/early stage rounds of funding and identifies: (a)
risks associated with the investment; (b) a risk mitigation plan;
and (c) a list of items that would need to be inserted in the
definitive documents in the nature of conditions precedent to
funding, conditions subsequent, representations and warranties to
be obtained from the founders, and indemnities.

Most startups spend a lot of time developing their business and
tend to neglect various legal and regulatory compliances. The
importance of a legal diligence cannot be underestimated given that
the investor will not write the cheque until they are satisfied
with the outcome of a legal diligence. Given the above it is
important for startups to put their house in order before
commencing fundraising initiatives.

Key aspects

A legal due diligence on a startup will cover five main areas:
(a) cap table; (b) regulatory; (c) intellectual property; (d)
agreements; and (e) employment.

Cap table: This includes a thorough check on
the issued and paid-up share capital of the startup. Startups often
fail to make important filings with the Registrar of Companies or
other regulatory bodies and have many small shareholders. It is
important for a startup to have a clean and a short list of
shareholders on its cap table as the lack of such a list could be a
nuisance during subsequent rounds of funding.

Regulatory: Obtaining appropriate registrations
and approvals for the nature of the business is also very
important. Startups often tend to take risks at the early stages,
which come to haunt them when they grow. It is imperative for
startups to seek appropriate legal advice at the inception stage.
Another regulatory aspect to be considered in cases of foreign
investment is the foreign direct investment norms. Since most
startups operate in the area of business-to-consumer e-commerce,
some structuring could be needed to facilitate the investment.

Intellectual property: It is important for
startups to ensure that the intellectual property which is a
valuable asset of the company is protected adequately. This may
include registering the intellectual property and entering into
detailed employment agreements, containing comprehensive
intellectual property assignment clauses, with members of the
research and engineering team. Founders should also ensure that
they are not violating any employment terms of any previous
employers. Startups often fail to take adequate steps to protect
their intellectual property.

Agreements: It is important for startups to
document their arrangements with suppliers, vendors, consultants,
etc. Startups generally are lax and fail to put in place formal
arrangements with third parties, which could help resolve a
dispute.

Employment: Various labour laws impose
penalties for non-compliance, in view of which it is important for
startups to understand the applicability and compliance
requirements of the relevant labour statutes.

Conclusion

The key to successful fundraising is recognizing and accordingly
preparing for diligence exercises and investor scrutiny from the
inception stage. Being prepared prior to even thinking of
fundraising will go a long way in ensuring a satisfactory outcome
when a fundraising opportunity arises.

It is also important to look at due diligence as a housekeeping
exercise and be open with potential investors about non-compliance.
This will help build a positive, trusting, working relationship and
establish the groundwork for an ongoing partnership.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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